Subscription Models Are Fine, but Memberships Are Stickier

Subscription business models have been around for a long time, with many of us becoming familiar with them via newspaper and magazine subscriptions. Today, we see them in streaming video services like the ones from Netflix NFLX or Disney DIS; in streaming audio offerings including ones from Sirius XM SIRI and Spotify SPOT; and in digital news subscriptions, be it from The New York Times NYT or others. We’re even seeing the term crop up with software companies, like ServiceNow NOW, and cybersecurity companies. Since you’re reading this as part of TheStreet Pro, it’s fair to say you have an idea of subscription business models.

In their simplest form, a company charges you a fee, which tends to be on a monthly or annual basis, in exchange for access to a product or service. As investors, we like subscription business models because they offer nice visibility, provided the subscription renewal rates remain high. As the subscription is paid — be it monthly, quarterly or annually — the company collects the payment and generates cash. Revenue is recognized over the term of the subscription, which is why we track revenue performance obligations (RPO) or deferred revenue for ServiceNow, Elastic ESTC and others when they report their quarterly results. In the case of The New York Times, the balance liability line item to look at is Unexpired Subscription Revenue. Rising RPO or deferred revenue figures are an indication of future revenue growth.

Subscriptions Are Good, Memberships Are Stickier

Membership business models, like the one we discuss with you when it comes to Costco COST, have similar characteristics with subscription business models but with one big difference. As American Express AXP once crystalized with one of its former slogans, “Membership has its privileges.” Membership business models provide customers (or members) with access to discounts, special offers on products or services and other benefits. In the case of Costco, you need to be a member to shop at either any of its warehouse locations or through its website or app to tap into favorable pricing it negotiates for its members.

At American Express, in addition to the charge and credit card offerings, membership brings other perks ranging from statement credits for various travel-related items to rental car insurance coverage. Depending on the card level one has at American Express, there are added benefits. For example, with the American Express Platinum Card, a member receives $15 in Uber Cash to use on eligible orders with Uber Eats and rides with Uber in the U.S. every month, plus a bonus of $20 in December. That’s a $200 per year value, which in some minds offsets the annual membership fee. The same platinum card also grants the holder $240 in digital entertainment credits, $200 airline fee credits, and a Walmart+ WMT monthly membership credit. All of those are perks of being a platinum card member and are things American Express negotiates on the membership’s behalf.

With subscriptions, you get the product you paid for, while with a membership you have access to services and additional perks.

While we like and utilize both, we must ask: Is one better than the other? When we look at the 90%-plus renewal rates at Costco and with American Express sharing that it has very high renewal rates, especially when consumers move to a higher price point membership, those high retention rates reflect the additional benefits of being a member.

Our thinking is it’s that added value that keeps renewal rates at lofty levels, bringing an added layer of visibility and predictability. It’s not that subscription businesses don’t have that, it’s that they lack other features other than the core service to fend off churn. So, if the quality of the service dips, or in the case of a streaming service the availability of fresh content wanes, unlike a membership business model, there is little else to keep a customer around. It’s those same perks and the ability to expand that offering that can help offset membership fee price increases, keeping membership churn low.

We have not seen many folks balk at Costco’s recent membership price hike and Amazon’s AMZN Prime membership keeps rising even though it has been boosting that price tag about every four years. Why? Because the associated value is greater than the membership fee. At Costco, the savings across a few trips cover the membership fee. American Express boosted the annual fee on its Gold Card to $325 from $250 in late July, which means it should see some nice lift to its Net Card Fee line item in the coming quarters from that. In exchange for that membership price increase, American Express added an additional $184 in credits that bring its total to over $400 in statement credits each year. It’s that perceived value that makes the membership business model much stickier compared to subscription business models. We don’t see American Express looking to defray its membership fee by serving up ads to its membership like we’re seeing at Netflix and Disney.

We also like the fact that membership business models tend to disclose their membership revenue as a line item on their income statement. With Costco, it’s the membership fee revenue line item, while at American Express it is Net Card Fees. At Amazon, they blur the line a bit by bundling their Prime membership fee revenue with those for digital and audiobooks as well as digital music and other non-Amazon Web Services Subscriptions in its Subscription Services revenue line that totaled $11.3 billion in the September quarter. That compares to $17.4 billion in operating income for the quarter. No matter what you call it, the reporting makes it easy to track but it also reveals that stream is a meaningful driver of profits and cash flow.

That membership fee revenue stream can be used for a variety of things. At Costco, it is used to expand the company’s footprint, while at American Express it helps fund its buyback program and fuel dividend increases. Rising membership fees happen over time, but given the value tied to the membership, they tend to be swallowed more easily than with subscription businesses. That in part helps explain why we are seeing video streaming services embrace ad-supported business models as they contend with rising content creation costs and the need to continually refresh that offering.

A sticky and growing membership base that brings predictability, cash flow and financial flexibility is a nice combination for investors. The key, of course, is not just overpaying for the shares but picking them up when the risk-to-reward tradeoff is more than favorable.

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At the time of publication, TheStreet Pro Portfolio was long NOW, ESTC, COST and AMZN.